Alts Hit Speed Bump in 2012

While the bloom is still on the alternative mutual fund rose, 2012 hasn't been as kind to alternatives as in years past.

Roughly speaking, alternatives currently represent $241.6 billion assets under management, with year-to-date flows of $19.9 billion, according to Cerulli Associates' data through October. This is down from $25.9 billion in 2011 and $52.4 billion in 2010.

So what's driving the slowdown in inflows? Performance may have something to do with with. For example, alternative mutual funds in the US Open End Bear Market category dropped 22.44% year-to-date through Dec. 11 versus its benchmark, which gained .49% during the same period, according to Morningstar. Funds in the US Open End Multialternative category gained 3.67% through Dec. 11 but were outpaced by the category's benchmark, which was up 4.33%.

Peter Andersen, chief investment officer of Congress Asset Management, attributed "frustrating" performance to unusual events such as the euro crisis and the U.S. elections causing the market to behave "irrationally."

"I think the reason why the performance has been lackluster has been due to the unusual number of world events that have caused periods of market correlation that we're not usually used to seeing, and that may make [alternatives] seem like market underperformers," he said.

It also doesn't help that advisers, while recognizing the value of alternatives in providing diversification and risk hedging in portfolios, don't know where to look, which strategies to invest in, or whether to take a chance on newer funds, according to industry participants. Distributors are open to adding alternatives funds but they're more selective about the funds they're adding to their platforms.

So what's going to bring advisers and investors back to alternatives? The answer is product development, according Nadia Papagiannis, director of alternative fund research at Morningstar. One example she points to is managed futures, which initially started off with index-tracking strategies, but have now morphed into funds of commodity trading advisors, with mutual funds managed by single hedge fund managers.

"The engineering of the product has gotten more creative," Papagiannis said. "There's more sector-focused stuff coming out, and firms are getting more niche managers to fill in the hole where the more general managers began."

Other industry observers' opinions vary widely as far the strongest categories within alternatives. For overall categories, director of research Alec Papazian at Cerulli Associates points to master limited partnerships, absolute return and managed futures as areas drawing the strongest interest.

Both Samuel Campbell, director of research at FUSE Research and Morningstar's Papagiannis see a lot of interest in multi-strategy, a "one-shop solution" for advisers who are new to alternatives and don't know how much to put in which funds nor which managers to turn to.

Papagiannis also highlighted long/short equity funds, which she said provide volatility-wary investors a "way of getting their seats wet without having to wade waist-deep" into stocks without any sort of risk hedge. However, Congress Asset Management's Andersen noted long/short as one particularly "frustrating" area where the performance has diverged greatly from market expectations. That said, he expected these strategies to "revive" once the U.S. has resolved its budget situation, exhibiting more "standard" return against long-only managers.

Top selling alternative funds through October include PIMCO StocksPLUS Total Return Short Strategy Fund (PSSAX), Mainstay Marketfield Fund (MFLDX), and Wells Fargo Advantage Absolute Return Fund (WARAX), which is sub-advised by GMO and has drawn $1.7 billion so far this year, according to Cerulli.

While Cerulli's Papazian noted declining interest in tactical-type funds that provide inverse or leverage exposure, chief executive officer Andrew Rogers of Gemini Fund Services said he sees "many more" of those funds coming to market. He also noted a long-term trend where typical long mutual funds are "migrating" to ETFs, while mutual funds in general are "really changing their characteristics" to become "much more hedged and tactical."

"Some of the larger players in the mutual fund industry may struggle as many of their assets move into ETFs. Also, with more hedge-type strategies among ETFs, typical hedge funds are going to have trouble raising assets also," he added.

That perspectives on different categories are so divergent is not surprising given that alternatives represent a "nascent" space, Papazian said. "Managers who are delivering returns are going to do well regardless what alternatives mutual fund category they're in. Even certain categories that aren't doing pretty well overall, managers who are doing well will be able to maintain their flows," he added.

So what should managers pay close attention to? FUSE's Campbell emphasized education and ensuring that advisers-and through them, investors-know what alternatives are and are meant to do. The role of broker-dealers in making sure their financial advisers understand these basics is crucial in helping temper investor expectations.

"This whole concept of your alternatives in your portfolio are doing what they're supposed to do, but compared to the rest of your portfolio, they look like they're underperforming-it's a market scenario that we haven't really had while alternatives were as popular as they are now," said Campbell. "I think it's a scenario that we could see how well advisers and asset managers have communicated what investors should expect from these strategies and how they should perform in various scenarios."

As for managers, Papazian advised that they should tackle specific categories within alternatives, rather than the space as a whole, when gauging whether these strategies "make sense" for their portfolios. Managers should also evaluate whether these strategies are truly part of their expertise. "So if your strength is fixed income and you want to do alternatives, don't suddenly go into MLPs where you don't have a prior presence," he said.

Morningstar's Papagiannis concluded that 2008 gave investors a false hope for what these strategies could achieve. "I think the challenge will be to demonstrate to investors that they even need alternatives when going long-only is going just fine for them," she said.